The Arrium/OneSteel affair has underlined basic weaknesses in our markets. We have seen those weaknesses exploited before but no raid has been more brazen than the attempt by one of the world’s largest steel makers, South Korea’s Posco, and partners to control more of its iron ore supplies and buy a key Australian company on a 2013-14 price earnings ratio of around four or five.
How in 2012 could this have happened? A wake-up call is required for all those involved, including corporate CEOs. Here's my take on the weaknesses, and how the Arrium/OneSteel situation exposed them and Posco was shown how to try and take advantage of them.
– Many Australian big superannuation funds are jittery. Through their own mistakes, the big funds have lost a third of the superannuation market to self-managed funds. They have often underperformed those self-managed funds. Most professionals only think short term because they are frightened of having money taken away, especially as the financial planning industry and the institutions have millions of lower income Australians too exposed to the share market. Arrium/OneSteel made decisions that trapped it in those underlying weaknesses.
– Inflexibility. Most professional managers and analysts had OneSteel classified as a steel maker. Global steel is "bad” and so OneSteel was "bad”. BlueScope followed the global pattern but OneSteel has become the world’s largest mining grinding ball maker and Australia’s fourth largest iron ore exporter. And it has its own port and infrastructure. Our institutions still had it classified as a steel company so it was "bad” and "deserved” a low price.
– Directors' mistakes. In an attempt to get out of the steel maker classification and therefore not be classified as a "bad” company they changed OneSteel’s name to Arrium. That made the situation worse because few then knew who Arrium was, except those that had it as a steel maker. Arrium/OneSteel borrowed large sums to expand iron ore exports. Suddenly it was a highly leveraged "bad” company. The shares went lower.
– The fundamental weakness is that the people who would buy shares in Arrium/OneSteel are not the blinkered institutions but those who now manage their own money. That’s where Arrium should have put its efforts. It’s not easy to do but any company that ignores one third of the nation’s capital market becomes vulnerable to Posco style raids if the legacy institutions have it in the "bad” books.
So as we stand Arrium has just doubled its iron ore production and completed the expansion on budget. There is no longer a construction risk. The returns will depend on the iron ore price. Arrium has debt of $2.2 billion but a gross operating cash flow estimated for 2013-14 of $420 million based on an iron ore price of $US110 a tonne (according to Merrill Lynch estimates). However, once you allow for dividends and routine capital investment, cash flow is about $220 million.
Again, on an iron ore price of $110 a tonne (it's currently $120) earnings per share are estimated by Merrill at around 15 cents. If ore prices stayed at $120 you would be looking at around 20 cents a share. So, depending on your view of the iron ore market, we are looking at a very low price to earnings ratio given the strategic nature of the company and its looming high dividend yield.
In my view Arrium has to start to market to self-managed funds. It also needs to lower gearing to make the investment more suitable for them. The shares are too low to make a placement but a fully renounceable rights issue going only to shareholders (where they can sell their rights) protects everyone and lowers gearing. The other alternative is to sell the port to shareholders as an infrastructure asset at a far higher earnings multiple than Arrium shares (the self-managed funds would love it).
Either of the above two courses would highlight the group’s position among self-managed funds. But the gearing is not currently high risk. For example, if Arrium sold the grinding operation (I am not suggesting it does) it would be worth around $1.7 billion, or almost the same level as the debt. The weaknesses in the established funds means once you are classified as a "bad” company it is very hard to get upgraded.